Sizing Up the New Cost Basis

The new federal rules governing cost basis reporting are a little elaborate, but the big picture is easy to grasp. Ever drive through a red light at a traffic intersection where one of those automatic cameras can snap a picture of your license plate, catching you in flagrante? The driver running the light is your investor client. The photographer is your custodian, broker/dealer, or anyone else who sends out 1099-B forms reporting trade results. After all, investors have been fudging cost basis on tax returns for years.

Starting this year, those days are over. Responsibility for cost-basis reporting shifts to broker/dealers and custodians, which will be required to start recording it in 1099-B filings for both investors and the IRS. For simplicity's sake, all sales of securities that were acquired before Jan. 1, 2011 are grandfathered out of the reporting requirement. Not all securities will be affected from day one; the government is phasing in the rules over a three-year period. They will apply to all equity transactions completed after Jan. 1, 2011; all mutual funds, dividend reinvestment programs, and most ETFs, acquired after Jan. 1, 2012; and other securities including fixed income and options purchased after Jan. 1, 2013. The IRS has not yet issued detailed regs on this third phase.

For financial advisors, the transition is not expected to be an easy one. Due to the way the new rules are written, advisors will need to pay close attention to which lots of any security they sell for clients, and can expect a lot of phone calls from confused customers looking for answers.

“Based on the reactions I've had at the presentations I've given, I would say many [financial advisors] really are not ready for this,” says Stevie Conlon, senior director and tax counsel at Wolters Kluwer Financial Services. “You always have some people who are really into all the aspects of what they need to know for their customers. But a lot of them are kind of compartmentalized, and they deal with those things when they have to. Maybe their philosophy is, ‘I don't do tax. They deal with tax at the end of the year with their tax guy.’”

But procrastinating is not going to cut it, she says. “These issues are not year-end issues. They fundamentally relate to the activities you're doing every day when you're buying and selling,” she says. And advisors who aren't paying attention could get grief from clients if there are unfavorable tax consequences from the new cost-basis rules on certain trades.

Closing The Gap

The government has known for years that it was getting shortchanged on capital gains. In 2001 alone, the IRS estimates, the failure to properly account for capital gains income contributed $11 billion to the gap between what taxpayers owed the U.S. government and what was actually collected. It's easy to see why; no reporting system exists to corroborate the claims that taxpayers make on their Schedule D (for trading income, income from professions and vocations, interest, overseas income and casual income), when calculating their capital gains or losses. Taxpayers don't offer a justification for their numbers unless they're audited. And many couldn't if they tried; documentation of basis is notoriously hard to come by if the securities were owned for a long time, or were subject to stock splits, or were gifted to or inherited by the seller. About 38 percent of taxpayers with securities transactions misreported their capital gains or losses for 2001, the Government Accountability Office said. On securities sales, a third of those actually over-reported their income, the GAO found.

“I've seen one audit in 27 years where the IRS was looking at cost basis on Schedule D,” says Lisa Osofsky, a CPA and partner who does financial planning at WeiserMazars LLP. “I can believe it's an area where they're losing revenues, because they're not looking at it that closely.”

Since custodians and some b/ds have tracked cost basis for their clients as a value-added service for years, legislators thought the rest of the industry should take up this burden as well so that the IRS could close the tax gap — in effect, a value-add for the government as well. When Congress needed revenue to offset the cost of TARP during the 2008 crash, proposed legislation that had languished for years was dusted off and jammed into the TARP legislation.

Some in the industry have likened the new practice to the W2 reporting that employers must provide to the government. It comes with a price, of course. The total cost to the custodians, b/ds and others who will have to track the paperwork runs about $528 million, according to the Financial Information Forum. The expected tax revenue to be generated over 10 years by doing the math correctly under the new cost-basis rules: $6.7 billion, according to the U.S. Congress' Joint Committee on Taxation. (To clarify, the $11 billion number for 2001 on the preceding page applies to all securities transactions, some going back decades, while the new cost basis rules only apply to securities that were acquired after Jan. 1, 2011.)

Setting aside the financial consequences, many financial advisors couldn't be happier with the new rules. For one thing, securities that are transferred from one advisor to another must be accompanied by a statement that outlines the cost basis; RIAs who had to track down that information in the past when bringing on new clients often found it an onerous task. Now it will be done for them by the preceding broker.

Another reason some advisors welcome the new cost basis rules involves certain dreaded conversations that tend to come up around tax time. “It's a very uncomfortable position we're put in when the client calls us and the client wants to know what to do, and what you're supposed to do and what you can get away with are two different things,” says John Burke of Burke Financial Strategies in Iselin, N.J., affiliated with Raymond James Financial Services. “You can't help the client evade taxes. You can get in a lot of trouble for that.” On the other hand, using the real number might generate a huge tax bill, leaving the advisor with an unhappy client. But there won't be room for this kind of conflict anymore, because there will be an official record of the cost basis.

Still experts warn that advisors can get in trouble with their clients if they don't move proactively on the new rules. Consider these pitfalls:

In the past, accounting methods that were used to calculate cost basis, such as first in first out (FIFO), were often selected by investors after the trade. Now, the methodology must be set before the settlement date of the trade; investors who think they can change the methodologies after the fact are in for a rude surprise. (The new law defaults to FIFO on equity trades. Different defaults can be set up, and can be overridden for specific trades.)

Lot selection also requires some thought. If you own 1,000 shares of XYZ Corp. that you've acquired in multiple lots over different periods of time, you can't sell 100 shares in 2011 and decide in 2012 which lot you meant to sell. The lot must be identified at the time of trade or before the settlement date.

To the discerning client, the difference will matter if the wrong lot is sold and the trade results in an inappropriate tax consequence, Conlon says. “I might yell at my advisor. I might say, ‘Dude, you told me to sell. I sold. But you didn't tell me I had to pick the lot my tax guy is telling me. And now I'm being told by my broker that it's too late. I can't change it. You cost me,’” she says.

Kevin McCosker, a director at Pershing who is closely involved with the firm's new cost basis reporting, says advisors should be attentive throughout the year to these consequences. “On a very small account, it probably doesn't mean anything. But on some of the larger accounts, it's something that you really have to pay attention to,” McCosker says. “The client should be paying attention, too. They should be talking to their broker as well as their tax person and should make sure they're in sync and make sure at the start of the year they know what their plan is for the next year.”

Pershing and other custodians have been actively preparing for the coming regime change with a variety of services for their client advisors, from white papers and web-based seminars to YouTube videos and toll-free telephone help lines. Charles Schwab has invested about $30 million to meet the reporting rules to the IRS as well as assist advisors with the questions that are likely to be posed by investors, says Brian Keil, Schwab's director of cost basis and tax reporting. The company delivers about 3 million 1099 forms to investors each spring.

“Even if 20 percent of those folks call us, that's 600,000 phone calls potentially coming in all within a couple of weeks,” Keil says.

Keil recommends that advisors develop a strategy that meets the needs of their clients. “Because Schwab and other custodians will be communicating to the clients the changes, and you want to be able to support the questions that are going to come in to your office,” he says. “If you help support CPAs and tax attorneys on behalf of your clients, which many of our clients do, make sure they're aware of what's happening. Don't assume that because they're tax attorneys and CPAs that they know how Schwab, for example, is going to handle these exchanges. Get ahead of all this and make sure your clients are educated.”